Startups and angels: Along the way to success

The Entrepreneur's Financial Toolbox

"I'm a first time entrepreneur and my opportunity could be substantial.  I'm going to be self-funding for a while but will almost certainly need money sometime, whether from partners, investors, or some sort of pre-sales arrangement.

So, my question is this:  What financial "tools" do I need to be successful? I see two schools of thought.  There are people who tell me to hire good advisors and the accounting firm can manage the financial details.  Others make it soundd like if I don't have an MBA in Finance I'm unqualified.  What do you think?"

--Mary Ellen, Indianapolis.

There are a minimum set of capabilities that an entrepreneur needs to be able to stay on top of her enterprise as it grows.  I'd define these as the capabilities that the entrepreneur should not rely soleloy on someone else's expertise to perform.  All of these will be relevant at some point in a company's life.  Some will be more or less important in the pre-revenue stage.

My list includes:

1.  Reading an income statement and a balance sheet.  Understanding how the two tie together.  Being able to explain where each entry comes from.  (i.e., Why is unearned revenue a liability? ) 

2.  Understanding ratio analysis and its impact on your relationship with your banker, as well as its competitive indications for your business.  Not many of us understand the nature of bank analysis.  Ratio analysis (sometimes called RMA ratios) are a critical factor in the way bankers analyze businesses.  They also provide good benchmarks for how the company's financial results line up against others in their industry who are similar in size and geographic location.  Of course, these are not so important if you are not borrowing money or are pre-revenue but they are still something the entrepreneur should understand.

3.  Knowing the revenue accounting standards for your industry and knowing how your revenue is being recognized by your financial manager.  We have a company that signs multi-year contracts but each contract has a 90 day notice termination clause.  Revenue cannot be recognized past 90 days since the contract can be cancelled.  This is a major source of restatement problems for companies of all sizes and in many industries. 

4.  Understanding cash acounting and its relationship to the income statement.  The entreprenejur should know the company's cash balance and be able to do a rudimentary forward looking cash flow analysis in her head. 

5.  Being able to calculate expected returns for the entrepreneur, co-founders, investors, and other stockholders.   This ability should include the understanding of indebtedness in the capital structure at the time of a harvest event, if any is planned.  This will lead to an understanding of the valuation metrics for the company and how daily activities will affect all of the stakeholders. 

6.  Understanding any variations from GAAP accounting in your company, and why.  Understanding who is making the decision to vary from these standards.  In today's environment, only one and two person never-to-grow-larger companies can disregard the issue of accounting standards.  Sooner or later everyone else will require bank financing, investment, divestiture, or some other outsider transaction that will trigger thorough financial reviews. 

7.  Knowing the particular buy-sell mechanisms of your company's ownership structure and the leverage implications for the major provisions.  I've seen a couple of busted deals lately in which the disputing owners have so much leverage from poorly drawn agreements that they can create very difficult situations. 

8.  Monitoring the status of all commitments, such as leases and debt instruments. 

Are You Learning Every Day?

I'm struck by the number of people I meet who are running new businesses that seem to repeat the same mistakes.  I'm certain this isn't because they want to; I also believe they have the ability not to. 

"Always make new mistakes," is the signature on Esther Dyson's emails. 

That's the idea. 

I have a friend, Bill, who is 60.  When he was 50, he decided to take up golf, never having played in his life. 

He was terrible, and few people wanted to play with him.  Today, he's the club champion with about a 3 handicap.  That's a highly unusual outcome.  What happened?

"Well," said Bill, "I realized golf takes a lot of time and I wasn't going to think of all that time as just recreation.  I decided that every time I took a swing I would learn something.  It took ten years, but now I know how to play and I avoid most of the common mistakes."

The conscious process of actively deciding to learn makes all of the difference.  Others played right alongside Bill for all those games and they aren't any better.  They also aren't more or less athletic, or enthusiastic.

They just don't have a focus on the activity at the moment, and an explicit expectation to learn from their experience.

And that's just golf.

Think how much more valuable this idea is if you apply it to anything that has some meaning, and not just a recreational exercise. 

The entrepreneur has the opportunity to master the intricacies of his business process; his customer's minute but important expectations; venture financing; people management.  The list goes on.  He can integrate advice within the context of his learning experience and learn from that advice more quickly.

All of this is the gift of awareness.

Are you learning something today?

Getting Over The Capital Hurdle

"My question is how you get over the capital hurdle when you have a product that straddles the fence between the need for Angel Investors and VC money and your friends and family cannot get you over the hump?" -- Bob

This is a complex question.  Let's just say that Friends money might be up to $100,000 or so; angels might go up to $500,000; and VCs really are going to start at a minimum of $5MM.

So, there is a gap between angel amounts and VC amounts.  So Bob is right in that there really is a kind of no man's land of 1MM to 5MM for many entrepreneurs who have a legitimate ability to use professional investment in their business venture.

One solution may be to try and derive the important milestones that the "next" investor will consider to be critical.  This makes the assumption that the entrepreneur can make progress spending small amounts of money that demonstrate viability and create interest in some way.

This involves a conversation with an investor that addresses the question "What would I have to achieve for you to invest?"  Possible answers might be prototypes, market tests, potential customer testimonials, or some combination of these and other factors.

  In other words, the entrepreneur wants to spend the least amount of money to eliminate the highest risk as perceived by the next investor in the company.

This is important because it will allow the entrepreneur to value the company more highly in the next round because the next round investor will value the reduction of risk that has occurred. 

By taking these risk reducing steps in increments, and assuming that the market is attractive to investors, the entrepreneur can achieve her goals.

For the first time entrepreneur, this will often mean starting with a bootstrap or friends and family model, or a combination of the two, to create some credibility for the product concept.

The other thing to think about in this situation is - can the entrepreneur reach the returns required by venture capital investors?  An extremely shorthand version of that is 30X the original investment in 5 years or less.  If the business has the potential to reach that level, great.  If not, staging investments in smaller amounts may work better. 

How Do You Teach Entrepreneurship?

The more interesting question is:

"How do you learn entrepreneurship?"

1.  From your prior experience that has given you granularity and knowledge of particular customer needs (opportunities).  The majority of us start businesses based on our previous work experiences.  RTMS, Inc. began when I saw an idea used for selling obstetrical equipment in 1980 (very targeted marketing) and made the connection to retail applications. 

2.  From the experience of others for which you have a framework.  If you are fortunate to be part of a network of entrepreneurs, you can validate what they tell you against what you know.  This is a very difficult task for most of us.  We have all said, "Yes, but this is different."  But most of the time, "it" isn't.  It is a little like Indiana Jones stepping off the precipice into the abyss, based only on his trust in the directions he had recieved. 

Those with more capacity to synthesize the epxerience of others go "up the learning curve" more rapidly. Good advisors are very important. Finding a way to pay close attention and validate their experience in the context of your business is a core skill for enrepreneurs working with advisors.   

Cases and simulations are another way to integrate the experience of others within your own experience. 

3.  From the study of entrepreneurial finance. Early on, I skipped this step.  The tuition I paid to learn it cost a lot more than any coursework ever would have.  We don't start businesses primarily for financial reasons.  We play baseball for the love of the game.  But we do know how to keep score.  Entrepreneurial finance is the same thing.  You (the entrepreneur) have to know how score is kept.  This is much more than accounting.  It goes directly to what investors expect, what the benchmarks of good financial performance are for the enrepreneur's particular business, what financing alternatives to consider, etc.  (Do you know what an RMA ratio is?  Ask your banker!)

4.  From self-awareness and personal growth.  There are no mistakes in the world; only lessons that keep repeating themselves until we "get it."  Great entrepreneurs examine every interaction, always looking for ways to improve, lessons to learn, ideas to synthesize and grow. 

5. By believing that knowledge is power and whistling past the graveyard is a fools game.   When I meet an entrepreneur who has command of market knowledge, it usually means she is going to be successful.  She knows the strengths and (inevitable) weaknesses of her company and its place in the market.  She can fairly assess risk; she is fully aware of what others are doing. She has a realistic handle on her costs and where the risks in the financial projections lie.

Compare this to the person with the 50-page business plan who, when asked a couple of 30,000 foot questions about others in the market, does not know.  "But," they say, "it's not important.  Microsoft, GE, or Gigantic Industries are so (conservative, slow, stupid) that they'll never see us coming until it's too late."  They forecast EBIT three times higher than anyone in the industry has ever achieved, but can't really explain why, aside from "more efficient cost structures." Whistling past the graveyard. 

So how do you teach entrepreneurship?  Perhaps a place to start is laying out this framework and providing opportunities to participate in each part. 

Angels and Cash Flow Deals

Why shouldn't angels like "cash flow" deals?  This comment was just posted:

"Since most angel investors are using their own personal funds why are cash flow deals less intriguing?  Assume a deal was structured such that the initial free cash flows were guaranteed to investors, say 2-3 times the initial investment amount, with cash flow sharing moving forward.  An entrepreneur would assume that they are guaranteeing the investor a certain rate of return with unlimited upside.  What are your interpretations of this deal assuming the product is a “one trick pony”? -- Patrick's comment

I assume this angel investor is not in the "friends and family" category.  That's important because cash flow deals probably are good for FF investors, since their reason for investing is probably more in support of someone they know than in an investing strategy.

Angels typically are investing as an investment activity. 

So, the reasons angels probably won't like cash flow deals:

1.  The returns are capped in most situations.  ("I'll give you 95% of the cash flow until you get two times your money," etc.)

2.  There's no opportunity to sell the business when the market values are high.

3.  The angel is tied into the business for a very long time and therefore has less time and/or less investable cash for other deals.

4. The absolute amounts of the cash flows will not in most cases be as good as the total of sale proceeds.

That having been said, I know quite a few investors who only do cash flow deals and who buy significant portions of companies and operate them.  This is a different category of investing and isn't really what most people think of as angel investors.

Competitors and Territory Maps

Most business plans have a competitive analysis section with a really nice grid.   Every one of those has a row for the entrepreneur’s company that, miraculously, gets a check in every column.

Of course, no other competitor scores as well on this objective standard, including all of the household names on the list.   

For the reader, the credibility flag starts to droop a bit.  As the reader digs deeper, he finds that one of the major product attributes of Microbig (that the entrepreneur doesn’t have) hasn’t made the screening list.   While this goes to the question of how the entrepreneur approaches the funding process, (a topic for another time), it also doesn’t do much for really understanding the territory the company is proposing to operate in. 

Territory mapping is a great way to begin to get at this idea in another way.  Here are some steps and examples.  Ask: 

1.    Who are the customers for the product we propose to offer at the finest level of granularity? (Not just "manufacturers," but "manufacturers with sales of less than $20 Million with unit production in the hundreds of thousands" etc. ) How many are there in the addressable market?

2.    What functionality are we selling and what is the total functionality to which ours is attached? 

3.    What parts of the total functionality equation are not in our product line?

4.    What is the overlap with our product and the other companies selling in this functionality continuum? Where else in our customer’s company does that functionality take them that it does not take us?   

5.    What are the revenue sizes of our competitors?   How much of their revenue is in our target customer segment?  (Central to their business, important but secondary, tangential, etc.)  Who owns them?

6.    Is their any complementary opportunity in our distribution requirements with each company providing functionality?

This train of thought can quickly lead to a much more robust discussion about competitive opportunity than a feature matrix.  It begins to help understand the nuances of how each other product is part of the customer’s solution set, and where our opportunities may lie across a number of dimensions. 

Who might be interested in allowing us to distribute their complementary solutions? 

Who might exit sooner rather than later?

Which companies have some sort of interlocking ownership? 

Who might be doing a rollup? 

From a resource point of view, who has more or fewer resources?  Etc.

Now a good entrepreneur knows all of this.  But an investor taking an initial look probably does not.  (Or, if they do, confirmation along these dimensions will almost certainly bring more credibility more quickly.) 

The ensuing discussion will often find two people – an entrepreneur and an investor – on the same side of the table talking about the possibilities for the business – quickly.

The CEO Needs To Sell…Again

Here’s a post from Jason Caplain , a VC in Ralieigh, NC with another take that adds more meaning to the discussion about the entrepreneur being the chief sales guy.  It casts a more refined light on the earlier post here. 

The whole idea of “time to raise money, no time to sell” is a keeper of an insight.

Don’t most Americans like to sell?  Apparently not by the appalling frequency with which this pattern repeats itself.  People seem to be willing to go to amazing lengths not to sell something to someone.   

After the seed/early stage, if the company is successful, a strong sales leader is going to be very important to new investors who will want to see capabilities spread over a team.

However, my contention is that even if there is a sales leader who is not the CEO on the founding team, the CEO has to be selling as a primary role. 

The company cannot get the pulse of the market into the product cycle and make the rapid, instinctive changes and improvements that come from customer contact if the customer contact is relegated to a “function” on the team.  It has to be the reason for being.

For even more on entrepreneurial sales, look up the work of Waverly Deutsch who teaches entrepreneurship at U of C and really understands the sales role!

Why Seth's "Don't" is 95% Right

Here's a succinct comment by marketing guru Seth Godin on funding companies.  Every entrepreneur thinking about funding a business ought to read it. 

"Don't," he says. 

Inevitably, investors invest in entrepreneurial endeavors because they believe in the endeavor and in their ability to make it disproportionately better if they are involved.  So, absolute and total control ends with the investment.  If this doesn't work for your business, don't take investment money.  Will investors fund companies that are really not appropriate candidates?  Sure.  There is plenty of money in the world.  Go read up on The Balance Health Stores and you'll see an example of investors who diverged from founders on the issue of growth.  On the other hand, the right investors in the right situation can be unbelievably powerful and of immeasurable benefit in an entrepreneurial company.  (Anybody see the Wily Technology deal in early 2006 for one example of how it ought to work?) See Bob Zieserl for examples of what works.

Are most companies appropriate for investment money (meaning venture kind of money?) No.  Probably 95% are not.  Doesn't make them poor businesses or bad ideas.  It makes them, as Seth says, "freelance ventures."  I parted with a partner once over that issue.  He wanted to be a critical worker in every project and I wanted an entrepreneurial business that grew disproportionate to my personal labors. 

Are cash flow deals good ideas, as Seth says?  Well they certainly can be.  Often the patient, small cashflow payback investor is someone you know and the capital is their own.  (Most venture investors, like pro golfers, are playing for someone else's money and they have time limits on when they must get the money back.)

The real gem here, though, is that comment about the economics.  If the deal won't come out economically, it is the market telling you it's not a great idea.